A Checklist for Commercial Landlords: What to Do Before Tenants Default

July 18, 2012

Originally Published in Commercial Executive Magazine.

The last few years have been a challenging time for commercial property owners in Arizona. According to CBRE MarketView, the metropolitan Phoenix retail vacancy rate at the end of 2011 stood at 12.2 percent, down only slightly from recent highs. Landlords are struggling to lease space despite aggressive rent reductions that have seen average net annual retail asking lease rates drop from almost $25 per square foot in 2006 to less than $16 per square foot today. And although the most vulnerable tenants have already closed their doors, the slow recovery means that landlords can expect additional rent relief requests and tenant defaults in the coming months.

Faced with this reality, property owners may be tempted to bury their heads in the sand and hope for the best. But while focusing on bad news is never fun, landlords who anticipate and prepare for defaults can limit the damage to their bottom lines.

The Downsides of a Reactive Approach to Tenant Defaults

When tenants stop operating or fail to pay rent, landlords who have not planned ahead are often left to make what feels like a no-win decision: pursue litigation against asset-poor defendants and risk throwing good money after bad, or let tenants walk away from their leases with impunity.

There are many benefits to taking legal action against tenants who default. For one thing, landlords who seek judgments send remaining tenants a signal that there will be consequences for breaching their leases. Successful lawsuits also open the door to powerful collection remedies. In addition to garnishing wages and bank accounts, landlords who secure judgments against defaulting tenants obtain an automatic lien on certain real property owned or acquired by these tenants in any Arizona counties where the judgments are recorded. And because judgments are enforceable for five years and are easily renewed, litigation can be a sound long-term strategy even when potential defendants do not currently have significant assets or income.

But with budgets tight and staffs stretched thin, landlords are rightly reluctant to move forward with litigation in hopes of uncertain future payouts. After all, if tenants and guarantors cease operations or file for bankruptcy, landlords can be left with little to show for the money they have spent on legal fees. Unexpected vacancies can also trigger co-tenancy-related rent losses or other concerns requiring immediate attention, so it is not always feasible for key employees to spend time preparing for a lawsuit in the aftermath of a tenant default.

Planning Ahead for Better Outcomes

Although landlords can’t control the broader economic conditions that contribute to tenant defaults, landlords can limit problematic vacancies and make litigation against tenants who default a more cost-effective option by taking a few key steps while tenants are still operating.

Look for Warning Signs

In order to limit the damage caused by tenant defaults, landlords should learn to anticipate problems before it is too late. Luckily, most defaults do not come out of the blue. Declining sales, sparse traffic, sudden changes in business models, and late payments are all warning signs that it may be time to take action.

Identify Goals

Once it becomes clear that tenants are struggling, landlords need to identify and prioritize among their goals. For example, if a disruptive tenant paying below-market rent starts to bounce checks, the landlord may want to retake possession of the space as soon as possible even if doing so would leave the landlord unable to obtain or collect on a judgment. Conversely, if a tenant’s default would trigger a co-tenancy provision in an anchor tenant’s lease, the landlord may want to do whatever it takes to keep the defaulting tenant operating. And in cases that fall somewhere between those extremes, landlords can review lease documents and gather information about tenants’ and guarantors’ assets in order to make informed decisions about how to proceed.

Consider Pre-Default Lease Amendments

Unless their primary goal is to regain possession as soon as possible, landlords should consider entering into lease amendments that provide struggling tenants with temporary rent relief. Used appropriately, pre-default amendments not only give tenants a chance to stay in business, but also reduce the cost and uncertainty of pursuing post-default litigation.

Landlords willing to offer pre-default amendments can sometimes obtain personal guarantees or other forms of additional security in exchange for rent reductions. Moreover, simply communicating with tenants about possible amendments gives landlords a chance to gather basic information that may come in handy in a lawsuit. For instance, current, off-premises notice addresses can reduce the costs of serving complaints and summonses if litigation becomes necessary, and up-to-date employment and bank account information can simplify post-judgment collections.

Properly drafted pre-default amendments also give landlords an opportunity to anticipate and eliminate defenses that tenants and guarantors might otherwise raise in a lawsuit. Even one-size-fits-all form amendments that detail past-due balances and require tenants to acknowledge that they have no defenses to liability can be of some help. However, form leases and amendments are often prepared by out-of-state lawyers who are unfamiliar with Arizona laws that affect key issues such as the validity of guarantees. And because landlords who work with local attorneys to draft targeted amendments can also identify and correct weaknesses and ambiguities in particular leases, landlords who may wish to pursue litigation will find that targeted, case-specific amendments are well worth the added cost.